Everyone likes to have cash on hand. There’s a sense of security you get knowing you have money in your pocket. But when you run a business, you want your money working as hard as you do. And too much cash sitting around in an account for too long is definitely slacking off. So how can you put your capital to work in the most efficient way possible?
First, let’s talk about what we mean by “working capital.” Working capital is the ready funds you have to meet your short-term obligations, such as your payroll, utilities, leases, and your vendors. You want your working capital to be sufficient for all of those needs. Otherwise, you’re operating at a deficit, and you’ll have to borrow, which incurs additional expenses. But you also don’t want to have too much working capital left over. Excess working capital is a negative because you’re wasting its potential. Ideally, any company asset should be utilized to bring in more revenue and increase the return for your investors. If you fail to do that, the growth of your business stalls and, if you are a publicly traded company, your share price can drop.
What can efficient working capital management achieve?
To sum up what we’ve been alluding to above, there are three main goals to managing your company’s working capital:
- Ensure the company has enough cash to cover expenses
- Minimize the cost of having to fund working capital
- Maximize the return for investors
To meet these goals, you’ve got to keep an eye on the relationship between your working capital and your obligations.
How healthy is your working capital ratio?
So, you want to have a what we call a “healthy working capital ratio.” You take your current assets and divide them by your current liabilities to get your working capital ratio. For example, if you have assets of $1 million and obligations of $500,000, your working capital ratio (aka current ratio) would be 2:1. That would certainly allow you to meet your obligations and even deal with some unexpected expenditures that might pop up. But if your obligations were only $250,000, the ratio would be 4:1, and that’s probably too high. The “health” of the ratio depends on the particular industry you’re in, but often a healthy ratio can be as low 1.2: 1.
But, you might ask, where are you getting the numbers for assets and obligations? That’s where proper benchmarking comes in. What we mean by current assets are items, such as cash in your accounts, account receivables, and inventory which can be converted into cash within a 12-month period. Likewise, your current liabilities are any obligations due within 12 months. But that doesn’t mean you should interpret your ratio as an annual number. You can complete the calculation monthly based on the last 12 months, so you get a sense of how your ratio fluctuates.
Suppose your working capital ratio drops from 1.6:1 to 1.3:1. Are you in trouble? Or is that drop a good sign? Of course, that answer depends on what caused the drop. The answer usually lies in one of three areas:
- Accounts receivable — Have your sales fallen off, or are you having trouble collecting in a timely fashion? You might need to improve performance in these areas.
- Inventory — There are substantial costs to carrying inventory, especially when it isn’t moving. Storage, insurance, interest, and losses due to theft can damage your working capital ratio, as well as your bottom line. Achieving targeted inventory levels is good for the health of any business.
- Accounts payable — Are you getting a good deal from your vendors? Is inefficiency costing you in terms of penalties and interest for late payments? Can you negotiate better payment terms from your vendors?
In many ways, your working capital ratio is like the “check engine” light on your car’s dashboard. It alerts you to a potential problem, but it does not pinpoint the precise concern. Often, it’s best to consult an expert who can help you determine your optimal level of working capital based on the nature of your business.
Contact Breon & Associates in Harrisburg
At Breon & Associates, we have extensive experience across numerous industries. Think of us as the mechanics who can look under your hood and tell you exactly what engine component needs to be tuned. Contact us today. With offices in Harrisburg and North Central PA, Breon & Associates provides business, accounting and tax services throughout Pennsylvania. Call us at 1-888-516-8476 or 717-273-8626, or contact one of our offices online to schedule an online consultation or an online training event.
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Harrisburg, PA 17101
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Camp Hill, PA 17011
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Ephrata, PA 17522
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Wyomissing, PA 19610